How much is too much?

Putting portfolio fees in focus

By Tousif Shaian Hafiz

For the savvy investor, it is imperative that they have a thorough understanding of the fee structures associated with any funds they are invested into, be they actively managed funds or passive options. While the most simple way to consider this dynamic is to examine the returns on performance net-of-fees, the reality of fund fees is more dynamic than that simple metric. The fees involved in these investments play a pivotal role in determining their overall performance and returns, but they are also useful in considering one’s own investment strategy. 

Let’s delve further into the intricacies of fund fees, their associated pitfalls, and look into what an astute investor may be looking for before making any investment decisions into a fund.

Actively Traded Funds: unravelling the fee structure and how much is too much?

In the world of funds, actively managed funds are the realm in which there is greater upside potential for return on investment, as well as greater downside. As the name implies, actively managed funds are overseen by portfolio managers and their teams that are constantly trading in different financial products that comprise their offerings with the primary goal being to outperform target benchmarks (often being market indices, hence the term ‘beating the market’). This style of investment tends to have a greater array of associated fees due to the greater overhead required to manage the portfolio, and generally include the following types of fees:

Management fees:

The most baseline fee in the standard actively managed fund costs, these are typically calculated as a percentage of the total assets under management (or AUM). The commonly used rate are ‘two and twenty’, where the portfolio management takes a fee of 2 percent of the AUM as a management fee. The management fee is typically used to cover the costs of research, management, payrolls, and administration within the fund.

Transaction fees:

These are the costs associated with the frequent buying and selling of different financial instruments and securities within the fund, such as brokerage costs. For certain types of funds, such as those that involve less liquid securities such as real estate, transaction costs tend to be higher as the gap between arrival and execution tend to be larger. 

Performance fees:

Performance-based fees (or incentive fees) are the other side of the ‘two and twenty’ rule. These fees are usually calculated as a percentage of the excess returns generated above the hurdle rate (usually about 20 percent), and are the ‘incentive’ for the fund to perform as efficiently as possible as the greater the return, the greater the performance fee will be.

The higher costs associated with actively traded funds and the inconsistent performances of these funds in general make them an area of investing that is best left to more skilled investors. The high costs can have a very strong cumulative effect on performance and have returns that were gross-above market suddenly become a return below that of the passive option quite quickly, especially if a fund has an inconsistent track record in beating its target indices. However, as these funds are actively traded and managed, they are also more able to take advantage of market gaps and attain abnormal returns which tend to be ‘de-risked’ out of the passive options, as those aim for stable benchmarked returns for conservative investors or those looking to ‘de-risk’ their portfolios. It is for that reason that investors should conduct greater due diligence regarding their actively managed fund investments in order to take advantage of a portfolio manager that may have a unique strategy in mind or is looking to invest in a thematic space that appeals to the investor, such as in biodiversity-related spaces, geographic locations, or specific segments of an industry. 

Passive Funds: safe, stable, and low risk

Passive funds, which commonly take the shape of index funds or ETFs, are trying to replicate the performance of a specific market index. Commonly traded products in this category are products such as Vanguard-500 (which tracks the S&P 500) and the SPDR S&P-500 (which tracks the same). The beauty of passive funds in this style is that they are generally very well diversified by nature, as they aim to track entire indexes rather than stay focused in specific subsets of industries, thematics, or commodities. These funds generally have lower fees due to the nature of their management style and fund composition, as they are more passively handled (hence the term ‘passive’).

Lower Management Fees:

Due to their passive nature, these funds have comparatively lower management fees associated with them. However, they still do often have a management fee that they carry as these funds still involve costs such as research, administration, and management to undertake tasks such as benchmark tracking.

Minimal Transaction Costs:

Similar to the aforementioned lower management fees, these funds still have transaction costs due to the goal of mimicking an index’s performance. However, as they are not necessarily aiming to achieve the highest overall return they have fewer transactions and generally have lower overall transaction costs.

However, it would be erroneous to consider passive options to be inherently safe. There is no such thing as a wholly safe option in investing, everything has its own set of challenges that investors and money managers must grapple with. In the world of passives, if a fund has an error in their benchmark tracking, passive funds may not be able to meet their goal of replicating their benchmark index performance, resulting in variances in returns or requiring a higher level of risk in order to do so. This is of course a very intuitive problem, as if it were the case that all funds were able to replicate their indices equally then there would not be a need for several competing products attempting the same feat to be on the market, and as such it can be worth the effort to find the most efficient choice for the same passive targets. Furthermore, passive funds tend to suffer from a greater degree of asset selection ‘drag’ – that is to say that they are limited in the degree of flexibility with which they can select composition assets during market changes. In exchange for that rigidity, they are much lower variance than more dynamic options.

How to navigate these waters as a savvy investor?

The astute investor should be familiar with the discussed dynamics and take reasonable due diligence on how they would like to approach investing into different funds. Consider the tradeoff between fees and performance.

The most simple approach is to simply consider the return on investment net-of-fees over the past 1-year, 3-year, and 5-year, or even 10-year periods. A fund charging higher fees doesn’t guarantee a superior return or track record compared to a lower fee option, and net-of-fees, more than 80% of funds on the market fail to beat the top performing passive within the same universe. Evaluating the historical performance against the listed fees is vital to avoid that pitfall.

However, before simply viewing it that way it is also imperative to understand the underlying investment thesis of the fund. Are the past few years performances doing poorly? Perhaps the fund manager has a 5- or 10-year investment strategy that they are executing, or they are heavily sector specific and that educated investors in that sector are understanding of that area and poor performance is not cause yet for alarm. Or perhaps a firm has been having significantly above average returns over the same period, it could be the case that they are heavily skilled in asset selection, or it could be the case that they are taking aggressive investment decisions and are exposed to significant risk. Investing in funds is a very information heavy world, and the more information one has at their disposal the better they will be able to invest.

Looking Ahead: the FUNDSaiQ Difference

What are the takeaways from all this? The first thing to keep in mind is that fees are necessary for any sort of professional portfolio management, but broadly speaking, getting fees down will improve returns. The second is that there are also very good reasons why an investor may be willing to pay a larger fee, that does not make them an ignorant investor having the wool pulled over their eyes. Some fund managers may have higher costs associated with a particular strategy or investment thesis, ESG-funds often have higher fees associated with investment due to higher costs for due diligence and compliance checks in portfolio companies, and some high performance funds often have higher fees alongside investment minimums to increase barrier to entry.

That being said, as with all things investment related, the most important thing is to learn and understand what you are investing in to and with whom. As has been discussed widely within the wealth management world, more than 80% of fund managers fail to beat key passive benchmarks, however, investors into these funds are still paying management fees, transaction costs, performance fees, and more. This is why it is imperative to explore the market to understand what options are available and to really understand the fund you are investing into on a granular level.

FUNDSaiQ is a powerful tool for resolving all these pain points in finding the right investment for clients. The platform allows for comparing the differentiated funds net of fees so performance can not mask exorbitant fees, and important information on the select funds are presented via the bespoke KIID sheets allows for truly well informed decisions to go beyond just the simple performance data. What that means is that FUNDSaiQ is able to present the pinnacle of actively managed funds from across different thematics and measure them against the pinnacle of the relevant passive options, rather than comparing average to average. For the astute planner and wealth manager what FUNDSaiQ is able to do is move them to the next level of efficiency and product awareness and open up a plethora of options that achieves the best for their clients as quickly and efficiently as possible.